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FINA2382 - Real Estate Finance Cheat Sheet (DRAFT) by

FINA2382 - Real Estate Finance

This is a draft cheat sheet. It is a work in progress and is not finished yet.

Real Estate Market Analysis

Stock Market, Property Market, Inflation
Major Sectors in Hang Seng Index Market Compos­ition
-Finan­cials (22.66%)
- Info Tech (25.09%)
- Properties & Constr­uction (14.21%)
- Consumer Goods (10.83%)
Correl­ation Coeffi­cients
- HS Index & Properties (0.895)
- HS Index & Finance (0.957)
- HS Index & Utilities (0.556)
- HS Index & ComInd (0.932)
Expected Portfolio Return
Rp = wA × RA + wB × RB
E Rp = wA × E RA + wB × E RB ; wA + wB = 1
Portfolio Variance
σp 2 = (wAσA) 2+(wBσB) 2+2ρAB wBσB wAσA
Optimal Portfolio
- Sharpe ratio, Rp − rf / σp = 5.21% − 0.6% / 16.17% = 0.285
Consumer Price Index
Real Estate investment as a hedge against inflation
- Based on return, property is a good hedge against inflation
- Based on volati­lity, real estate more volatile than CPI, long-term hedge against inflation, not short-term hedge
Reside­ntial Real Estate
- Not public, under I not C
Macroe­conomy and Property Market
Stock Market, Property Price and Rental
Financial Events
- Anti-s­pec­ulative measures (1995)
- Handover (1997)
- Asia Financial Crisis (1997-­1999)
- Recession (1997-­2002)
- SARS (2003)
- Recovery (2004)
- Global Financial Crisis (2008)
Lead-lag Relati­onship
- Stock
- Property Price
- Rent
Correl­ation Coeffi­cients
- HSI & Price (0.47)
- HSI & Rent (0.38)
GDP and Property Price Indices
Coeffi­cient Correl­ation
- GDP & ABC (0.66)
- GDP & DE (0.63)
- GDP & All (0.66)
Real GDP = Production
Capital Inflows During the Financial Crisis
Causes of Fund Inflows
- Quanti­tative easing led to abundant liquidity and increased risk appetite
- Weak US dollar and near-zero interest rates fuel carry trade in emerging market
- 100% Deposit Guarantee by HKBS until end of 2010; safe haven
- Active property market since the beginning of 2009
Potential Risks
- Inflat­ionary pressures
- Asset-­price bubbles
Real Estate Market Activities and Bubbles
Rental Yield
Rental yield = Annual rent / Current Price
- the lower the rental yield, the higher the property price
Mainland Visitors and Private Retail
- Increase in Mainland visitors boost retail business
Vacancy Rate and GDP Growth
Correl­ation Coeffi­cient
- GDP & A (-0.48)
- GDP & C (-0.61)
- GDP & E (-0.47)
Price Index Trend
- Private Domestic Price Index
- Rental Index
- Prices and rents have returned to pre-crisis levels
- Price above rental index because of decreased land supply and increased liquidity
Property Market Trend HKMA Framework
- Real property prices; deflating the nominal property price index by the CPI
- Real new mortgages; total amount of new mortgages, deflating the nominal values by the CPI
- Transa­ction volume; Sales and purchase agreements
- Income leverage; Ratio of debt payment to HH income
- Buy Rent Gap; Mortgage payment to rent ratio, high when specul­ative or strong property ownership
- Confirmor transa­ctions; buyer resells to sub-pu­rchaser before the legal completion of the original sale
Wealth Effect of Real Estate on Consum­ption
- Increase in wealth effect boost consum­ption
declines in asset prices might have only limited impact on local consumers
- Multiplier effect; wealth effect could lead to decrease in invest­ment, fall in GDP, falling income, shrink in consum­ption
Supply and Demand Conditions
Household Formation
- Dynamics of population pool
- Lifestyle and economic situation
- No of new HH
- Ave HH size
Household Income
Importance of ownership
- Homeowners tend to be more econom­ically produc­tive, boost economy and property price, vice versa
Supply for Shelter
- Decrease in supply when the price index and rental index is decreasing
Vacancy
- Vacancy t = Vacancy t-1 + Completion t - Take up t - Deprec­iation
Afford­ability Issues
Afford­ability Index
- Median HH income / Average monthly mortgage payment
- Bank mortgage lending policy; HH income > 2x or 3x Mortgage payment
- AI < 2, low afford­ability
- AI < 1, unaffo­rdable
Problems of Afford­ability Index
- HH income may not be the only source of income, like personal savings and invest­ments
- Mortgage payment consists of principle and interest, compare interest with rent
- HH income only reflects local afford­ability not overseas
Rise and Fall of Property Price
- Too high; afford­ability issue
- Too low; banks unwilling to lend (deter­ior­ating L/V ratio), high interest rate, increase in default rate to cut loss

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Bubbles and Crashes
Bubble
- asset prices move because they are expected to move
- the price moves away from fundam­entals based solely on expect­ations of further movements
Examples of Bubble
- Japanese asset price bubble (1985-­1991)
- Dot-com bubble (1999-­2000)
- Post-c­risis property market in HK
Why Do Bubbles Arise?
- Shortage of store of value
- Agents misbehave
Rational Bubble
- Realise price is divorced from fundam­entals, but believe that price rises will persist for some time, and that price growth will compensate for the risk
- Irrational bubbles involve unreal­istic expect­ations about asset's future prospects
- If everyone knew that at period (T+j) that the bubble would burst, then no one would pay the bubble price at period (T+j-1); bubble unravels
Stochastic Rational Bubble
- q x b
t+1
= (1+r)b
t

- b
t
= v
t
- v*
Affordable Property Price
- Calculated based on a fraction of median household and other mortgage assump­tions
- b
t
= Actual price
t
- Affordable price
t

- mortgage rate = r
Stochastic Rational Bubble Implic­ations
- Commod­ities with close substi­tutes puts limits
- r =< the growth rate of the economy
Effects of Bubbles
- distor­tions in resource allocation
- Financial collapses
Nature of Property and Capital Market
Prices of Houses
- How many households wish to own the units
- How many units are available for ownership
- Demand to own real estate = Supply
Supply of New Real Estates
- Property price > Constr­uction cost + Land (increase in supply, vice versa)
- In the long run, property price = constr­uction cost + land
Rent affect Price
- In the market for real estate use of space, demand comes from the occupiers of space
Firm's Use of Space
- Production technology
- Output levels
- Relative cost of space
Househ­old's Use of Space
- Household income
- Relative cost
Rent
- For tenants, rent is lease agreement
- For owners, rent is the annualised cost associated with the ownership of property
Rent Determ­ination
- Determined in the 'property market' for space use, not in the 'asset market' for ownership
Four-Q­uadrant Framework
Quadrant 1: Property Market for Rent Determ­ination
- D(R, Economy) = S
- If the economy changes, then the entire curve shifts
- Inelastic demand; demand curve is nearly vertical
- Elastic demand; demand curve is more horizontal
Quadrant 2: Asset Market for Valuation {{n}} - P = R/i
- i = capita­lis­ation rate = R/P = slope of the valuation curve = represents the current yield to hold real estate assets
Components of Capita­lis­ation Rate
- Long term interest rate
- Expected growth in rent
- Risks with rental stream
- Tax
- Exogenous
Quadrant 3: Asset Market for Constr­uction
- P = f(C)
- f(C) = replac­ement cost
- Greater building activity increases the replac­ement cost
Same cost at any level; vertical curve
- Inelastic supply; horizontal curve
Quadrant 4: Property Market for Stock Adjustment
= change in S = C - delta x S
- S = C/delta
Equili­brium and Disequ­ili­brium
Equili­brium
- The property and asset markets are in equili­brium with each other when the starting and finishing levels of stock are the same
Disequ­ili­brium
- If the starting stock is less than the finishing stock, the rents, prices, and constr­uction must decrease to be in equili­brium, vice versa
Effects of Exogenous Shock
- An increase in demand for space; Increases in R, P, C, and S
- A decrease in capita­lis­ation rate; increase in P, C, S and decrease in R
- An increase in constr­uction costs; decrease in C, S and increase in R, P